You're Doing It Wrong

Nearly three-fourths of advisors currently use alternative products or strategies, but some could be going about it all wrong.

The wealth management industry is fully embracing "alternative investment" strategies and pouring more client money into them. But some asset managers say advisors still have a long way to go when it comes to really understanding these investments and effectively integrating them into their clients' portfolios.

Nearly three-fourths of advisors currently use alternative products or strategies, according to a survey by Cogent Research. Fifty-six percent of advisors surveyed see an important role for alternatives in their clients’ portfolios. Yet there are some things that advisors still need to get straight, according to an alternative investments panel that spoke Thursday in New York. For starters, the definition of alternatives can be misunderstood, said Rick Lake, portfolio of The ASTON/Lake Partners LASSO Alternatives Fund.

Lake defines alternatives as short sales of stocks or other means of hedging against a portfolio's potential losses, investing in futures or derivatives, and possibly goosing returns with leverage. These kinds of alternative investments are making a bet on the direction of the market more than buying a direct cash flow from an underlying security. Others argue that investments that do generate cash, like REITs or master limited partnerships, are alternative investments.

A Dangerous Word

Integrating these "alternative" assets into a client's portfolio requires understanding how they will act in concert with other investments. Many advisors use the word "uncorrelated" with clients to describe the role these investments will play, providing some hedge against losses in the broader market. But they need to be careful, Lake said. Correlation is a very straightforward statistic: It tells us if two asset classes might be moving in roughly the same direction. But it’s based on past performance, and that doesn’t tell us anything about how the asset will behave in the future.

“So things that were uncorrelated in one period might be less correlated in the next period,” Lake said. “Zero correlation can produce zero returns in a positive environment, and negative correlation can produce negative returns.”

There are few strategies in the broad alternatives category where no or negative correlation actually holds up when you need it the most, said Jeremy Radcliffe, co-founder and managing director of Salient Partners.

For example, long/short equity and relative-value strategies tend to get more correlated when equity markets suffer. The strategies should be used more for reducing volatility, not for their correlation benefits, Radcliffe said. Otherwise, clients are going to be surprised when these strategies do move with the markets.

“For that reason, I think you need to be very specific in dealing with clients in talking about why you’re adding a strategy,” he said.

Alpha: Not the Holy Grail

When it comes to alternatives, a lot of advisors think of "alpha," or the relative return of an investment above what is expected given the risk, as the Holy Grail, but that’s really a misplaced conception, Radcliffe said. The main focus should be on getting a portfolio’s core market exposure right, then look for an alternatives approach to balance that exposure.

“Alpha really is more of a tertiary goal in terms of building a solid portfolio,” Radcliffe said. “A lot of things that we thought were alpha 10 years ago or 15 years ago, turns out they may not be alpha in the strict definition of something that’s idiosyncratic to a specific manager.”

"Alternative beta," which gains returns for risk in a passive investment model, is much more interesting, Radcliffe added, because it’s more widely available and more consistent than alpha.

“We think it’s fun to hunt for alpha, but it’s a difficult task because alpha by definition is a zero sum game,” Radcliffe said.

Jury’s Out on ETFs

While most advisors access alternatives using mutual funds (78 percent), 59 percent also use ETFs to get exposure to the asset class, according to Cogent. But that may be a mistake, Radcliffe said.

“I think the jury’s still out on ETFs from an alternatives perspective,” he said. The problem with some of these longer-term alternative strategies, such as managed futures, is that they aren’t attractive for day-to-day trading. Most alternative strategies are more buy-and-hold.

“The issue with that is that if you don’t have people trading it on a regular basis, you don’t have the trading volume that allows buy-and-hold investors to get in and buy it in any size without moving the market around,” Radcliffe said. We’re going to have to see much more trading volume in some of these ETF strategies for them to be attractive to buy-and-hold investors, he added.